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Could Bill Ackman’s Genius Be His Downfall?

Philip Pearlman

The Exchange•September 26, 2013

Speculation has swirled since the middle of the year over Bill Ackman's hefty short position in Herbalife Ltd. (HLF). With the stock having risen substantially above Pershing Square Capital's average entry price, the Street is buzzing over whether Ackman has been covering or hedging his approximately $1.7 billion position with options.

Reuters

True to his word, it looks like Ackman is sticking to his controversial bet against Herbalife.

There was no change in short interest on Herbalife over the two-week period from August 30 to Sept. 13, even as shares climbed 13% to $69.35 on heavier-than-average volume over the same time frame. This suggests the rally was not attributable to short covering, as many speculated, but instead to real demand for shares. Additionally, short interest in the name as a percentage of float remains extremely high at around 40%, leaving the shares susceptible to a squeeze.

Who Wants to be a Millionaire?

Readers might recall that, in December 2012, Ackman walked through an infamously bearish 345-slide presentation ironically titled Who Wants to be a Millionaire? at a special three-hour Sohn Conference in New York City.

It was a bombshell in which Ackman argued HLF was a pyramid scheme and said he planned to short the stock to zero. The day before the presentation, HLF closed at $42.50. Four trading days later, it closed at $26, down a quick 38%.

Since then Ackman's fortune has turned as other large and influential investors, including Carl Icahn, George Soros and most recently Post Holdings (POST) CEO Bill Stiritz, have gotten involved on the long side and, like Ackman, have gotten loud about it.

HLF stock has benefited, moving from that December 2012 low of $26 to a recent new all-time closing high of $73.46 on Sept. 19.

Reuters

In a recent email exchange, Tim Ramey, senior research analyst at D.A. Davidson, summarized what we can glean from Pershing Square's August 2013 performance report regarding the HLF position. Ramey writes:

Ackman had a single short position and was 14% short on a $10.7 billion portfolio as of August 31st... With a $61.01 closing price for HLF (end of August), you get a short of 24.5 million shares +/- 0.8 million shares for rounding.

Given the most recent short interest data cited above, it does not appear Ackman has covered since the end of August. So another $8 rise in the stock (x 24.5m shares) equates to another $200 million loss so far just this month.

It would not be like Ackman to cover anyway after making such a large and public presentation outlining his case. As recently as August 12 on The Charlie Rose Show, Ackman stated that he was short the stock and reiterated similar language. "I'm an investor who has made a bet the business will fail and we believe Herbalife is operating a pyramid scheme," he said.

But the fact remains that, the higher Herbalife goes, the larger the position gets, both nominally and as a percentage of the Pershing Square portfolio.

Beating the MBIA Beast

This is not the first time Ackman has found himself up against the ropes.

In late 2002, Ackman took a large short position in shares of MBIA Inc. (MBI) and bought credit default swaps on its debt, betting against the financial institution's aggressive credit positions. It was a complicated and bold bet right into the teeth of an economic recovery which culminated in the housing bubble and subsequent financial crisis.

It took five years for MBIA stock to finally crash at the end of 2007; at one time Ackman was estimated to be down more than 50% in common shares. He finally sold the swaps and covered the stock in early 2009 after MBIA shares crashed. Ackman made a lot of money and, deservedly, became a hero as chronicled in Christine Richards' excellent Confidence Game.

The MBIA trade brought Ackman rock star status. He stared the beast down and beat it by maintaining conviction to his thesis and patiently riding it out while the voting machine went against him.

Ironically, the epic short and the accolades may have conditioned Ackman for his current situation. After being positively reinforced for entering a portfolio-threatening situation that went his way, he now finds himself in the early stages of perhaps a similar but more dangerous situation. What if Herbalife simply continues to go much higher?

Nobody's Bigger Than the Market

Some of the same traits that make investors great might ultimately lead to their downfall.

Many of the best stand apart from the herd and remain true to themselves, ignoring megatrends (or bubbles) the way Warren Buffet avoided Internet stocks in the late 1990's while a 28-year old fund manager was calling him out on financial television.

Ultimately, there's a fine line between conviction and hubris marked by keeping losses manageable, regardless of past successes.

This time, Ackman is swimming alone and facing attack by some of the biggest and most experienced sharks out there in Soros, Icahn and Stiritz. No doubt they smell blood — and that's why they're there.

In a way it's admirable. Ackman is doing what he does, putting his name on the line yet again and willing to put the risk on. But it's a double-edged sword. You must commend Ackman on his conviction but at the same time you must at some point begin to question his risk management.

As of the end of August, Pershing Square was still up 0.3% net year-to-date, according to the Pershing Square, L.P. August portfolio update. Arguably, Ackman deserves credit for keeping the fund in the black given the greater than $500 million loss he has taken so far in HLF and the hit he took earlier in the year in J.C. Penney (JCP).

However, in the past five months, HLF has doubled, going from $35 to $70, an $850 million move on 24.5 million shares short. Were it to double again over the next five months, it would cost Ackman's hedge fund $1.7 billion.